Dollar hits 14-year sterling low; euro/yen at new record

European currencies rally on hopes of further interest-rate increases

By

WanfengZhou

NEW YORK (MarketWatch) -- The dollar fell to a 14-year low against the British pound and two-week low versus the euro Tuesday, on growing expectations of further interest-rate hikes in Europe and as oil prices rebounded.

The pound rallied sharply, with traders flocking to the U.K. currency amid expectations that this month's surprise interest-rate increase may be followed by another upward move. Sterling also benefited from gains in the euro sparked by surprisingly strong French economic data.

The dollar's "new year recovery appears to be losing momentum, with a lot of good news already in the price," said Mitul Kotecha, head of global foreign-exchange strategy at French bank Calyon. "We believe that interest rate markets are overly hawkish in the U.S. and overly dovish in the euro zone."

The dollar "is likely to find it tough in making further headway over coming weeks."

Late in New York, the euro stood at $1.3028, compared with $1.2947 late Monday, after rising to $1.3044, the highest level since Jan. 9. The dollar was quoted at 121.59 yen, compared with 121.62 yen.

The British pound traded at $1.9822, compared with $1.9759. It had earlier touched an intraday high of $1.9915, the loftiest level since 1992. The dollar also changed hands at 1.2416 Swiss francs, compared with 1.2491 francs.

The euro fetched 158.43 yen, compared with 157.47 yen, after touching a new record high at 158.33 yen. See live currency rates.

The dollar registered a limited reaction to a report that showed the U.S. index of leading economic indicators rose last month. The Conference Board said the index increased 0.3% in December, the fastest pace seen in three months. The increase was in line with expectations of economists polled by MarketWatch. See full story.

A rebound in oil prices also put some pressure on the dollar, said Ashraf Laidi, chief foreign-exchange analyst at CMC Markets in New York.

Soaring sterling

Bank of England Governor Mervyn King said in a speech Tuesday that the "balance of risks to output growth and inflation has shifted towards the upside." He also said that by responding early to changes in the inflation outlook, the bank "ultimately needs to raise interest rates by less than would be the case if we delayed."

The minutes from the central bank's policy meeting earlier this month will be released on Wednesday. Earlier, the Confederation of British Industry reported that January manufacturing output rose to a 12-year high in the last quarter.

The "minutes should read hawkishly, with the odds pointing towards the next U.K. rate hike in February, "said David Brown, chief European economist at Bear Stearns, in a note.

Since a surprise move by the central bank in early January to lift its key interest rate by a quarter point to 5.25%, statistics have showed that consumer-level inflation is running at a 3% pace, and that December retail sales jumped more quickly than anticipated, leading many to conclude the Bank of England will make back-to-back rate hikes in February.

The central bank's "aggressive rate policy response is simply turning sterling's appreciation into a self-feeding, virtuous circle -- as the prospect of a break through the psychological $2.0 mark beckons soon," Brown wrote.

ECB bets

The euro gained after French consumer spending on manufactured goods climbed a surprisingly strong 1.3% in December, well ahead of the 0.3% monthly rise that economists had forecast. Separate data showed euro zone industrial output rose 1.4% in November.

European Central Bank board member Lorenzo Bini Smaghi said that interest rates are still accommodating and that "if the growth scenario is confirmed, not adapting interest rates would mean increasingly excessive liquidity."

Meanwhile, ECB governing council member Axel Weber also suggested that the central bank had to act preemptively to protect price stability.

The euro is gaining "as dollar sentiment deteriorates across the board and hawkish remarks from the European Central Bank bolster the euro as well as the chances of a March rate hike," Laidi said.

Yen: weak 2007

Elsewhere, the yen retained a soft tone, touching a fresh record low against the euro. The minutes of the Bank of Japan's 18-19 December interest-rate meeting showing several members arguing in the direction of a policy tightening didn't have much impact on the market.

Nick Bennenbroek, currency foreign-exchange strategist at Brown Brothers Harriman, said comments from Bank of Japan governor Toshihiko Fukui that the bank has no pre-set schedule for its next rate move is "a mild negative for the yen." Fukui said Friday that a rapid unwinding of carry trades could disrupt markets and hurt Japan. But he didn't express immediate concern about the yen carry trade, according to Bennenbroek.

Adam Cole, senior currency strategist at RBC Capital Markets, noted that the yen is likely to weaken rather than strengthen in 2007, even though the Bank of Japan is expected to "hike rates in February and again in [the second-quarter]."

"A combination of rising Japanese retail demand for overseas assets, declining institutional hedging and on-going use of [the yen] as a funding currency in carry trades suggests [the yen] will again defy the consensus expectation of appreciation." Yen carry trades refer to the practice of speculators making profits by borrowing the yen at low costs and reinvesting in higher-yielding currencies and assets.

RBC revised its year-end forecast for the dollar/yen rate to 125 from 110. It expects the euro to rise to 166 yen, from a previous forecast of 146 yen.

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